2. Behavioral biases (S11.1) Look back to the cash flows for projects F and G in Section 5-3.

The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are overstated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects’ sponsors, instructs them to use a discount rate of 18%.

a. What are the projects’ true NPVs?

b. What are the NPVs at the 18% discount rate?

c. Are there any circumstances in which the 18% discount rate would give the correct NPVs?

(Hint: Could upward bias be more severe for more-distant cash flows?)